Money and Monetary Policy

Meaning and Functions of Money
• The functions of money
– medium of exchange – means of storing wealth – means of evaluation – means of establishing value of future claims and payments

• What should count as money?
– narrow definitions of money – broad definitions of money

Financial System in the UK
• The key role of banks
– deposits and loans – liabilities and assets – retail and wholesale deposits and loans

• Liabilities
– sight deposits

Balance sheet of UK banks: February 2003

Balance sheet of UK banks: February 2003

Financial System in the UK
• The key role of banks
– deposits and loans – liabilities and assets – retail and wholesale deposits and loans

• Liabilities
– sight deposits – time deposits

Balance sheet of UK banks: February 2003

Financial System in the UK
• The key role of banks
– deposits and loans – liabilities and assets – retail and wholesale deposits and loans

• Liabilities
– sight deposits – time deposits – certificates of deposit

Balance sheet of UK banks: February 2003

Financial System in the UK
• The key role of banks
– deposits and loans – liabilities and assets – retail and wholesale deposits and loans

• Liabilities
– sight deposits – time deposits – certificates of deposit – repos

Balance sheet of UK banks: February 2003

Balance sheet of UK banks: February 2003

Balance sheet of UK banks: February 2003

Balance sheet of UK banks: February 2003

Financial System in the UK
• Assets
– cash and balances with the Bank of England

Balance sheet of UK banks: February 2003

Balance sheet of UK banks: February 2003

Financial System in the UK
• Assets
– cash and balances with the Bank of England – short-term loans

Balance sheet of UK banks: February 2003

Balance sheet of UK banks: February 2003

Balance sheet of UK banks: February 2003

Financial System in the UK
• Assets
– cash and balances with the Bank of England – short-term loans – longer-term loans

Balance sheet of UK banks: February 2003

Balance sheet of UK banks: February 2003

Balance sheet of UK banks: February 2003

Balance sheet of UK banks: February 2003

Balance sheet of UK banks: February 2003

Financial System in the UK
• Liquidity and profitability
– profitability – liquidity
• the liquidity ratio

Balance sheet of UK banks: February 2003

Financial System in the UK
• The central bank
– Bank of England, ECB, Fed, etc. – functions
• note issue • acts as a bank
– to the government – to overseas central banks

• overseas activities of banks • provides liquidity to the banks
– lender of last resort

• operates monetary and exchange rate policy

Financial System in the UK
• The London money market
– the discount and repo markets
• discounting • the repo market • last-resort facilities by Bank of England

– the parallel money markets
• the inter-bank market • inter-companies deposit market • market for certificates of deposit, etc. • foreign currencies market

The Supply of Money
• Definitions of the money supply
– monetary base – broad money

• Definitions in the UK
– definitions in the UK: M0, M4

UK monetary aggregates: (end February 2003)
£ million Cash outside Bank of England + Banks’ operational deposits with Bank of England = M0 36 861 91 36 952

Cash outside banks (in circulation) + Private-sector retail bank and building society deposits = Retail deposits and cash in M4 (also known as M2) + Private-sector wholesale bank and b.s. deposits + CDs = M4

30 630 676 969 707 599 295 996 1 003 595

UK monetary aggregates: (end February 2003)
£ million Cash outside Bank of England + Banks’ operational deposits with Bank of England = M0 36 861 91 36 952

Cash outside banks (in circulation) + Private-sector retail bank and building society deposits = Retail deposits and cash in M4 (also known as M2) + Private-sector wholesale bank and b.s. deposits + CDs = M4

30 630 676 969 707 599 295 996 1 003 595

UK monetary aggregates: (end February 2003)
£ million Cash outside Bank of England + Banks’ operational deposits with Bank of England = M0 36 861 91 36 952

Cash outside banks (in circulation) + Private-sector retail bank and building society deposits = Retail deposits and cash in M4 (also known as M2) + Private-sector wholesale bank and b.s. deposits + CDs = M4

30 630 676 969 707 599 295 996 1 003 595

The Supply of Money
• Definitions of the money supply
– monetary base – broad money

• Definitions in the UK
– definitions in the UK: M0, M4 – euro zone definitions: M1, M2, M3

UK monetary supply using ECB measures:
(end February 2003)
£ million Currency in circulation + Overnight deposits = M1 + Deposits with agreed maturity up to 2 years + Deposits redeemable up to 3 months' notice = M2 + Repos + Money market funds and paper = M3 31 351 513 292 544 643 81 696 296 518 922 857 88 978 57 496 1 069 331

UK monetary supply using ECB measures:
(end February 2003)
£ million Currency in circulation + Overnight deposits = M1 + Deposits with agreed maturity up to 2 years + Deposits redeemable up to 3 months' notice = M2 + Repos + Money market funds and paper = M3 31 351 513 292 544 643 81 696 296 518 922 857 88 978 57 496 1 069 331

UK monetary supply using ECB measures:
(end February 2003)
£ million Currency in circulation + Overnight deposits = M1 + Deposits with agreed maturity up to 2 years + Deposits redeemable up to 3 months' notice = M2 + Repos + Money market funds and paper = M3 31 351 513 292 544 643 81 696 296 518 922 857 88 978 57 496 1 069 331

The Supply of Money
• Definitions of the money supply
– monetary base – broad money

• Definitions in the UK • The creation of credit

The Supply of Money
• Definitions of the money supply
– monetary base – broad money

• Definitions in the UK • The creation of credit
– simple illustration

Credit creation: Banks' original balance sheet

Credit creation: Effect of a new deposit of £10bn

Credit creation: Full effect of a new deposit of £10bn

The Supply of Money
• Definitions of the money supply
– monetary base – broad money

• Definitions in the UK • The creation of credit
– simple illustration – the bank multiplier

The Supply of Money
• Definitions of the money supply
– monetary base – broad money

• Definitions in the UK • The creation of credit
– simple illustration – the bank multiplier
• 1/L

The Supply of Money
• Definitions of the money supply
– monetary base – broad money

• Definitions in the UK • The creation of credit
– simple illustration – the bank multiplier
• 1/L

– the real world

The Supply of Money
• Definitions of the money supply
– monetary base – broad money

• Definitions in the UK • The creation of credit
– simple illustration – the bank multiplier
• 1/L

– the real world
• no precise bank multiplier

The Supply of Money
• Causes of increases in money supply
– banks reduce liquidity ratio – inflow of funds from abroad – PSNCR and its financing

• Money supply: exogenous or endogenous?
– Relationship between money supply and the rate of interest

The supply of money curve: (a) exogenous money supply MS

Rate of interest O Quantity of money

The supply of money curve: (b) endogenous money supply MS

Rate of interest O Quantity of money

The Demand for Money
• The motives for holding money
– transactions and precautionary motive – assets or speculative motive – the total demand for money

• Determinants of demand for money
– money national income – frequency with which people are paid – financial innovations – speculation about future return on assets – rate of interest

The demand for money (liquidity preference) curve

Rate of interest

Md
O Money

Monetary Equilibrium
• Equilibrium in the money market
– equilibrium interest rate where D and S of money are equal

Equilibrium in the money market
MS
Rate of interest

re

Md
O Me Money

Monetary Equilibrium
• Equilibrium in the money market
– equilibrium interest rate where D and S of money are equal

• Equilibrium in the foreign exchange market

Monetary Equilibrium
• Equilibrium in the money market
– equilibrium interest rate where D and S of money are equal

• Equilibrium in the foreign exchange market
– increased money supply leads to lower interest rates

Monetary Equilibrium
• Equilibrium in the money market
– equilibrium interest rate where D and S of money are equal

• Equilibrium in the foreign exchange market
– increased money supply leads to lower interest rates – lower interest rates lead to a lower exchange rate

Monetary Equilibrium
• Effects of changes in money supply on national income
– effect on interest rates
• Ms↑ → r↓

The demand for and supply of money
MS

Rate of interest

r1

Md
O Q1 Money

The demand for and supply of money MS ' MS

Rate of interest

r2

r1

Md
O Q2 Q1 Money

Monetary Equilibrium
• Effects of changes in money supply on national income
– effect on interest rates
• Ms↑ → r↓

– effects of changes in interest rates on investment
• r↓ → I↑

Monetary Equilibrium
• Effects of changes in money supply on national income
– effect on interest rates
• Ms↑ → r↓

– effects of changes in interest rates on investment
• r↓ → I↑

– effects of changes in interest rates on the exchange rate, and imports and exports
• r↓ → er↓→ X↑, M↓

Monetary Equilibrium
• Effects of changes in money supply on national income
– effect on interest rates
• Ms↑ → r↓

– effects of changes in interest rates on investment
• r↓ → I↑

– effects of changes in interest rates on the exchange rate, and imports and exports
• r↓ → er↓→ X↑, M↓

– effects of changes in investment, imports and exports on national income
• I↑, X↑, M↓ → Y↑

Monetary Policy
• The significance of monetary policy • The policy setting
– relationship between the government and the central bank – degree of central bank independence

• Medium- and long-term policy
– control of banks’ liquidity ratio – restricting size of PSNCR

Monetary Policy
• Short-term monetary control
– techniques to control money supply
• open-market operations • reduced central bank lending to the banks • funding • variable minimum reserve ratios

– techniques to control interest rates
• announcing changes in interest rates • backing up announcements
– operations in the discount and repo markets

– credit rationing

Effectiveness of Monetary Policy
• Medium and long-term control over the money supply: reducing PSNCR
– automatic fiscal stabilisers – the desire to cut taxes – difficulty in cutting government expenditure

• Short-term control of the money supply
– use of money supply targets – ways in which banks resist attempts to restrict the growth in the money supply – demand-determined money supply

Effectiveness of Monetary Policy
• Effectiveness of controlling interest rates
– inelastic demand for loans
• problem of possibly high interest rates

An inelastic demand for loans

Rate of interest

Assume that the authorities want to reduce the demand for money to Q2

r1 Demand for loans O Q2 Q1

Loans

An inelastic demand for loans

Rate of interest

r2

A large rise in the rate of interest (to r2) will be necessary

r1 Demand for loans O Q2 Q1

Loans

Effectiveness of Monetary Policy
• Effectiveness of controlling interest rates
– inelastic demand for loans
• problem of possibly high interest rates • reasons for an inelastic demand for loans

Effectiveness of Monetary Policy
• Effectiveness of controlling interest rates
– inelastic demand for loans
• problem of possibly high interest rates • reasons for an inelastic demand for loans

– unstable demand for money

Effectiveness of Monetary Policy
• Effectiveness of controlling interest rates
– inelastic demand for loans
• problem of possibly high interest rates • reasons for an inelastic demand for loans

– unstable demand for money
• problem of changing expectations

Effectiveness of Monetary Policy
• Effectiveness of controlling interest rates
– inelastic demand for loans
• problem of possibly high interest rates • reasons for an inelastic demand for loans

– unstable demand for money
• problem of changing expectations • speculation

Effectiveness of Monetary Policy
• Effectiveness of controlling interest rates
– inelastic demand for loans
• problem of possibly high interest rates • reasons for an inelastic demand for loans

– unstable demand for money
• problem of changing expectations • speculation

– possible conflict between domestic goals and exchange-rate goals

Effectiveness of Monetary Policy
• Effectiveness of controlling interest rates
– inelastic demand for loans
• problem of possibly high interest rates • reasons for an inelastic demand for loans

– unstable demand for money
• problem of changing expectations • speculation

– possible conflict between domestic goals and exchange-rate goals

• Using monetary policy

Effectiveness of Monetary Policy
• Effectiveness of controlling interest rates
– inelastic demand for loans
• problem of possibly high interest rates • reasons for an inelastic demand for loans

– unstable demand for money
• problem of changing expectations • speculation

– possible conflict between domestic goals and exchange-rate goals

• Using monetary policy
– use of interest rates to meet inflation target

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